UK pension funds do not typically replace a liability-driven investment mandate once they have appointed a manager. Why is that, and could the DWP’s view that derivatives are exposed to climate risk make ESG integration a future differentiator? 

 

Although reviews of mandates do take place, pension funds have so far typically stuck with their LDI manager. A recent survey by mallowstreet in partnership with BMO Global Asset Management found that 88% of schemes were not planning to change manager, with 86% saying they are happy with the existing relationship, though 71% said they would review them if there were recurring issues with inefficient execution. The same percentage said this was true if there were regular issues with the timeliness and quality of service. 

 

Many survey respondents said that a change would be too time consuming compared with the potential benefits of doing so.  

 

Traditional LDI “is a commodity, and you wouldn’t generally have a reason to change your LDI manager any more than your passive equity manager. It's not really a value-add service,” said Natalie Winterfrost, a director at LawDeb Pension Trustees. Schemes agree the hedge they want in place and the manager implements it, and so the only real reason for replacing the manager would be operational issues, “but that would be the exception", she argued. 

 

One of LawDeb’s clients has changed manager for synergy reasons, as one employer had several schemes using different LDI managers. Another reason why schemes may start to review LDI mandates is that there has been a tendency to look at buy-and-maintain or cashflow-driven investment mandates and there could be synergies in having the same manager, she said. “If you’ve got an existing LDI manager, they may not be your preferred credit manager,” she noted, saying that there is more to consider in the appointment of a credit manager. 

 

 

The juxtaposition of LDI and credit brings up the question of choice in the LDI manager space. The Financial Conduct Authority said in the 2017 final report of its asset management market review that there was no need to analyse the LDI market in depth. The finding may seem surprising because at the time just three managers – Legal & General Investment Management, Insight Investment and BlackRock – held the vast majority of the market, and industry was split on whether the market was working well. 

 

Winterfrost said while a few years ago she would also have focused on the three dominant LDI managers, “I do think that list has extended”, and trustees would expect to see other names on a consultant’s list, such as BMO and River & Mercantile. 

 

In some ways, smaller managers can be preferable to being a big LDI house, she maintained. “If your book is all LDI... your counterparty knows what side of the trade you’re going to be on,” she said, making it potentially harder to be nimble enough. 

 

Reviewing LDI managers on an ongoing basis to ensure they remain fit for purpose and value for money is important, argued Stuart Walters, a trustee director at 20-20 Trustees. “All too often LDI managers are appointed and not reviewed despite an ever-growing pool of assets,” said Walters, adding: “I have seen downward pressures on price – and have recently negotiated fee reductions in excess of £100k per annum. This is an area where trustees can add value.” 

 

Competition between LDI managers appears to be increasing, said Danielle Markham, head of LDI at consultancy Barnett Waddingham.  

 

“As schemes look to de-risk, LDI managers want to establish themselves as the core part of investment strategies for the long term,” she said. Most LDI managers are therefore expanding their services, with an increasing number offering products which will fit alongside LDI as part of schemes’ endgame portfolios, such as buy-and-maintain credit and bespoke LDI-plus growth mandates.  

 

“They don’t want to lose existing clients or lose out on expansion of services to another manager that has more flexibility in the types of products they can provide,” she said. 

 

Markham has also seen some downward pressure on fees, with some sizeable discounts being offered to investors on the newer funds being launched, “to help try to entice clients away from their existing managers”. 

  

While the process-driven nature of LDI make this a ‘sticky’ investment, pension funds are not invariably happy with their LDI manager.  

 

“We are aware of schemes who are in the process of moving to a new LDI manager,” she said. “But managing the operational risks of transferring is a time consuming, costly and difficult process,” she added, as different managers have different dealing schedules and pricing points, as well as different leverage levels, duration and other fund design issues which mean exposure cannot be transferred like for like. 

 

 

Unlike the FCA, the Department for Work and Pensions is less inclined to simply accept the status quo. In a recent consultation on climate risk reporting, some schemes had wanted to see exemptions for matching assets or closed schemes. The ICI Pension Fund, for example, said: “The Trustee believes that cash, gilts (including gilt exposures gained via derivatives or repo), interest rate and inflation swaps and bulk annuities, should be excluded from the asset test.” 

 

However, the department rebuffed these attempts to become exempt from reporting, saying: “All derivatives will be exposed to climate risk in 'the underlying', as well as counterparty risk like any other asset, and some commentators have set out how these risks might begin to be evaluated.” 

 

mallowstreet's survey shows that pressures to incorporate ESG criteria into LDI mandates are expected to increase; half of respondents felt ESG integration needed improving among LDI managers. 

 

But how feasible is this? Winterfrost thinks that at a high level, ESG should be implemented across the portfolios, but noted that where the derivative is on a macro factor like interest rates, it is unclear how to do this. Where schemes use gilts total return swaps, however, the case is different, she noted, although even for government debt, ESG thinking is not very developed. “It’s an interesting challenge,” she said, but “one we shouldn’t shy away from”. ESG assessments could be made of counterparties, she added. 

 

Still, for a new LDI mandate with a credit aspect, she would expect ESG to be an essential part of any manager’s pitch because the often long-dated debt tends to be held to maturity, and so “the sustainability of that asset is absolutely essential to understand”. ESG could “well be a differentiator” for LDI managers going forward, she said.  

 

Alan Baker, another LawDeb director, said: ““I’m pleased that the DWP have resisted calls to exempt LDI from ESG requirements." 

 

While the scope of what can be achieved might be more limited, for schemes it is important to get a complete picture of the climate impact and other aspects of ESG from their investments, he believes. 

 

“I’m aware of some managers who have extended their ESG reporting to pick up credit and I’m hopeful that will put pressure on others to do the same. There is always the question of who is being lent the money, whether it’s corporate bonds or sovereign debt, and equally there is the S and the G of the asset manager themselves to consider,” said Baker. 

 

 

For Simeon Willis, chief investment officer at consultancy XPS Pensions Group, the primary issue is the counterparty selection, “but it is a far lower magnitude of impact, with fewer levers to pull than ESG in other assets”. 

 

Most managers are not very active in this space, he noted, although “there are some examples of good ESG in counterparty selection”.  

 

He said the prospect of green gilts, recently announced by the government, create scope for ESG to be more of a factor in LDI, but argued that it is not clear to what extent a green gilt could be seen as risk or return enhancing, unlike ESG assessment more generally. “This is because there is not expected to be any difference in terms of credit enhancements – they will all be government backed to the same degree,” he said.